Question to all…
In one of the Scweser mock exams, it said that an increase in unearned revenue indicated a lower earnings quality but for some reason this does not sound right to me.
Can you anyone provide some help? I know the test is over but this one is driving me nuts.
Thanks!
Hi,
Basically unearned revenue is an obligation to perform services/ deliver products to customers, which is a LIABILITY to the company until the obligation is fullfilled.
Stop dwelling on it! Exam is over so move away from the books… 
Haha, yeah just kind of popped into my head so can’t shake it at the moment. But how does it affect earnings quality? Decrease or increase indicates higher/lower quality?
HIGH unearned revenue DECREASES earning quality in several ways…
Recognizing unearned revenues today lowers future revenues.
Unearned revenue is a liability and it does not represent “real” earnings by the company.
Higher unearned revenue is accompanied by higher accrued expenses (matching principles), both of which decrease earning quality.
I hope this makes more sense.
A lot more sense…it was just one of those topics I grappled with because (at least I think), decreases/increases unearned revenue can be open to interpretation (i.e. a decrease could mean recognizing too soon).
Oh well, does not matter now I guess. Thanks for responding!
Unearned revenue is a liability. Usually, a higher value under this account is more conservative and more representative of GAAP/IFRS. If this account decreases, you’re recognizing revenue on your books, so it allows management to boost top/bottom line.
Although subtle, this account can also be used as a “smoothing” item. Management may show more liabilities today so that they can recognize revenue later. So an increase in this account can also reflect a lower quality.
Ultimately, you need to look at the changes in this account over time. Looking at one year (in real life terms), won’t tell you anything.
The way the CFA texts have covered this: a huge decrease in this account is indicative of poor quality. So in that sense, Schweser is wrong. And I’m not surprised because Schweser is wrong in many other places.
Thanks. That is what I hate about Schweser. I found many times that doing something the way they taught it conflicted with the actual CFA books. Iguess it just pays to use the curriculum after all, regardless of how much information is present.
del
Damn, Ivan. You beat me to the post before I could quote you. Your quote about unearned revenue being thin air was not completely accurate. Unearned revenue is part of the firm’s working capital. If managed properly, it can be a pretty robust source of cash. Heck, it is even interest-free money.
Aha, ofcourse, and your clients are stupid. This source of cash comes early but it comes as a reduced amount of cash (early payment discounts). Therefore there is always unwinding of discount on deferred revenue (if material ofcourse). IAS 18 is unbeatable.
There is no interest-free money in this world.
I have seen enough journal entries to refute your claim. It is all about managing cash flow. Every time my current liabilities go up, I’m counting on my clients to be stupid. Had you said manipulating deferred revenue is unsustainable , I’d have agreed with you. But claiming that unearned revenue is created out of thin air is a bit (actually, a lot) far fetched. This is real cash sitting in your account. Outside of true manipulation, you’d have to be an archeologist to not use that cash.
Without naming names, one of the US companies I looked at recently, uses this same tactic (zero percent liabilities) to deal with its counterparts in emerging markets. Call it exploitation or an act of God, it is an advantage for the US firm, albiet a short-lived one.
Here are some real life examples that I can actually name, assuming you have access to historical data: AboveNet, DigitalGlobe, GeoEye. Up until 2012/2011 cycle, DigitalGlobe was clocking in like a -90% negative NWC, with a pretty healthy FCFF.
Edit: Just to clarify, AboveNet was acquired by Zayo while GeoEye was acquired by DigitalGlobe. That’s why I hinted at historical quotes.
Ohh man, I’m just too tired of all this. Simply not excited about this stuff. Sorry for not wishing to argue. However, you definetely have a point.
LOL, I love you, too, Ivan. I’m just trying to make stupid posts on AF to try and not think of July 23rd. No matter how much I try though, the sucky feeling won’t go away. All day, I keep asking myself: what if I fail and what if I pass.
point 1… recognizing unearned revenues today increases the future revenues in my opinion. I mean thats the purpose behind recognizing unearned revenue so when you are looking into the future that your revenues are going to fall, you start decreasing the liability(UR) and increasing the revenue.
Unearned revenue comes about when you already receive the cash, but have not performed the service. Therefore, recognizing UR does not increase your future revenue. What is increased when you release the UR is your profit, artificially.
That said, either an increase or decrease in UR could be indicative of lower earnings quality. Decrease, for obvious reason. Increase, because you haven’t known the actual expense that would be incurred yet. For all you know, it could be well above the cash you received.